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Introduction to Corporate Finance

Chapter I

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The Balance-Sheet Model of the Firm

Current assets

Fixed assets

1. Tangible fixed assets

2. Intangible fixed assets

Current liabilitiesNet working capital

Long-term debt

Shareholders’ equity

Total Value of Assets

Total Value of the Firm to Investors

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Basic Concerns of Corporate Finance

• What long-term investment strategy should a company take on?

Investment Decisions

• How can cash be raised for the required investments?

Financial Decisions

• How much short-term cash flow does a company need to pay its bills?

Working Capital Decisions

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Capital Budget & Capital Structure

• Capital Budgeting & Capital Expenditures: The process of making & managing expenditures on long-lived (term) assets

• Capital Structure: Represents the proportions of the firm’s financing from current & long term debt and equity

• Net Working Capital: Short term management of cash flow during operating activities

Current Assets minus Current Liabilities

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The Value Of The FirmValue of the firm = Value of Debt + Value of Equity

V = B + S• Creditors / debtholders / bondholders: Lenders of funds at

the predetermined cost (interest) & the predetermined time of repayment / buyer of debt (bonds) from the firm

• Shareholders: The holders of equity shares

• Shareholders’ equity = Value of assets – Value of debt = residual claim

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Pie Model of the Firm

50% equity50% debt

Capital Structure 1

25% debt

75% equity

Capital Structure2

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Cash flows between the Firm & the Financial Markets

Firm invests in assets

Current assets

Fixed assets

Financial markets

Short-term debt

Long-term debt

Equity shares

GovernmentTotal value of assets Total value of the Firm

to investors in the financial markets

Firm issues securities to raise cash

Cash flow from firm’s operations

Taxes

Retained cash flows

Dividends & debt payments

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Value Creation Issues

• Value Creation is generating more cash through firm’s operations than raising through financial markets

• Identification of Cash Flows

• Timing of Cash Flows

• Risk of Cash Flows

Accounting Profit versus Cash FlowsABC Limited

Income Statement for Year Ended June 30

Sales $1,000,000Costs - 900,000 Profit $ 100,000

Cash inflow $ 0Cash outflow -900,000

$ - 900,000 9

Cash Flow Timing

Year Product A Product B 1 $ 0 4000 2 0 4000 3 0 4000 4 20,000 4000

20,000 16,000

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Risk

Pessimistic Most Likely Optimistic

Europe $ 75,000 $ 100,000 $ 125,000

Japan $ 0 150,000 200,000

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The Corporate Firm

• The firm is a way of organizing the economic activity of many individuals

• Three basic legal forms of organizing firms

– The Sole Proprietorship

– The Partnership

– The Corporation

The Sole Proprietorship1. Business owned by one person2. It is the cheapest business form3. Minimum legal requirements4. All profits of the business are taxed as personal

income (No corporate tax)5. Unlimited liability for business debts &

obligations. No distinction is made between personal and business assets.

6. Life is limited by the life of the owner7. Opportunities to raise funds limited

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The Partnership1. Any two or more persons can get together and form a

partnership.2. Two categories: 1) General partnership 2) Limited

partnership3. Easy & inexpensive to form4. Written documents are required in complicated arrangements5. General partners have unlimited liability for all debts6. The general partnership is terminated when a general

partner dies or withdraws 7. It is difficult for a partnership to transfer ownership8. Difficult to raise large amount of cash9. Income from a partnership is taxed as personal income to the

partners ( No corporate taxes)10. Management control resides with general partners11. Usually a majority vote is required on important matters

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The Corporation (Company)• Incorporated Association• Artificial Legal Existence• Perpetual Existence• Common Seal• Extensive Membership• Separation of Management from

Ownership• Limited Liability• Transferability of Shares

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A Comparison of Partnership & Corporation

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Corporation Partnership

Liquidity & marketability Shares can be exchanged without termination of the corporation. Common stock can be listed on stock exchange.

Units are subject to substantial restrictions on transferability. There is usually no established trading market for partnership unit.

Voting rights Usually each share of common stock entitles the holder to one vote per share on matters requiring a vote & on the election of the directors. Directors determines top management.

Some voting rights by limited partners. However, general partner has exclusive control & management of operations.

Taxation Corporations have double taxation: Corporate income is taxable, and dividends to shareholders are also taxable.

Partnerships are not taxable. Partners pay personal taxes on partnership profits.

Reinvestment & dividend payout

Corporations have broad latitude on dividend payout decisions.

Partnerships are generally prohibited from reinvesting partnership cash flow. All net cash flow is distributed to partners.

Liability Shareholders are not personally liable for obligations of the corporation.

Limited partners are not liable for obligations of partnerships. General partners may have unlimited liability

Continuity of existence Corporations have a perpetual life. Partnerships have limited life.

Goals of the Corporate Firm

• To add value for the stockholders

• Set-of-contracts view point: The corporate firm will attempt to maximize the shareholders’ wealth by taking actions that increase the current value per share of existing stock of the firm

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Agency Problem & Control of the Corporation

• Principal – Agent Relationship: Shareholders are the principals and the management team are the agents

• Conflict of Interest between principal and agent = Agency Problem

• Agency Costs: The costs of the conflict of interest between stockholders and management.1. The monitoring cost (Direct Cost)2. Expenditures that benefits management (Direct

Cost)3. Opportunity Cost (Indirect Cost)

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Managerial Goals• Expense Preference• Survival: Organizational survival means

that management will always try to command sufficient resources to avoid the firm’s going out of business.

• Independence & Self-sufficiency: This is freedom to make decisions without encountering external parties or depending on outside financial markets.

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Separation of Ownership and Control

• Diffuse shareholder ownership• Shareholders select the members of the board of

directors• Board of directors select the management team• Contracts with management and arrangements for

compensation• Fear of takeover gives managers an incentive to take

actions that will maximize stock prices• Competition in the managerial labor market – fear to be

replaced

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Financial Markets

Classification According To Maturity Of Securities

• Money Markets: The markets for debt securities that will pay off in short term (usually less than one year)

• Capital Markets: The markets for long-term (with a maturity at over one year) debt securities and for equity shares

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Financial Markets

Further Classified as:

• The primary market

• The secondary markets

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Financial Markets

The Primary Market: New Issues

• Where governments and corporations will initially sell securities

• Corporations engage in two types:– Initial Public Offering– Private Placement

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Financial Markets

Secondary Markets• After debt & equity securities are originally sold,

they are traded in the secondary markets.• Types: Auction Markets & Dealer Markets• The Auction Market: Mostly for equity securities,

e.g. Karachi Stock Exchange, NYSE• The Dealer Markets: Mostly debt securities

– Over-the-counter (OTC) market: Dealer market for equity securities, e.g. NASDAQ

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